Interest rates and the rupee

The “markets” and the corporate sector, the media report, are once again disappointed with the Reserve Bank of India. With growth slowing persistently and inflation thought to be less of a concern than earlier, the RBI was expected in its Mid-Quarter Monetary Policy Review in June to continue with its recent turn to reducing rather than hiking interest rates. That shift, recorded in April (see Chart), was seen as signalling a longer-term change in policy focus from combating inflation to spurring growth. Prior to April, over a period of two years and in more than a dozen steps, the RBI had hiked the base repo rate by as much as 3.5 percentage points to its October 2011 level of 8.5 per cent. The motivation was clear: inflation was seen as India’s most important problem, necessitating measures to moderate demand by discouraging investment and consumption.

However, in April, the RBI was seen as sending out a strong signal with a full fifty basis points reduction in the repo rate to 8 per cent. Since that has had little visible effect either on demand and growth or on confidence in the markets, expectations were that the RBI would persist with rate cuts and monetary easing. What is more, even the outgoing Finance Minister, Pranab Mukherjee, suggested in public that this was the way the RBI would respond.

However, on June 17, the RBI chose to stand firm, and leave the interest rate unchanged, inviting media and corporate criticism. The argument advanced by the critics sounds painfully obvious. Since, in their view, inflation is moderating while growth is decelerating, the RBI should have stuck with the policy of cutting rates. By adopting an asymmetric attitude with respect to its two tasks of combating inflation (for which it continuously hiked rates) and reviving growth (for which it must continuously reduce rates), the central bank’s leadership has, it is argued, chosen to be excessively conservative. In sum, the corporate sector is looking to the “independent” central bank for a bail out.

One among the many problems with this argument is that it presumes that inflation and growth are the only two concerns weighing on the minds of central bank officials. There are, however, other concerns in most contexts, important among which is the management of the exchange rate in countries with liberalised exchange rate systems. In India’s case, an issue agitating the government and the central bank is the close to 25 per cent depreciation of the rupee via-a-vis the dollar over the last year, which has brought its value to the current level of around Rs. 57 to the dollar. The sharp and persisting depreciation of the currency makes the task of halting and reversing its decline crucial for both the government and the RBI.

The rupee’s depreciation has implications even for the task of addressing inflation. A falling rupee increases the domestic prices of imports. Such increases, especially those in the prices of imported universal intermediates like oil, tend to aggravate domestic inflation. Seen in that light the objective of stalling the rupee’s decline should take precedence over that of directly addressing inflation.

Two sets of factors are known to underlie the rupee’s depreciating trend. The first is an increase in the trade and current account deficits on the balance of payments as a result of the rise in the prices of oil and the sharp increase in the imports of gold. The other is the decline in the volume of net capital inflows into the country, largely as a result of the outflow of FII investments in recent months. What has been particularly disconcerting is that despite the moderate fall in oil prices in recent weeks, which would have reduced the strain on the trade and current account balance, the rupee’s depreciation has continued.

In other circumstances a depreciating rupee would have helped shore up the balance of payments by reducing the dollar prices of India’s exports and increasing the rupee prices of imports. Falling export prices would increase global demand for Indian goods and rising import prices would restrict the domestic demand for imports. However, with the world economy in recession, export demand has not risen in response to falling prices. On the other hand, the domestic demands for commodities like oil and gold, which account for a large proportion of the increase in India’s import bill, are also not sensitive to prices. So the depreciation of the rupee has not helped to correct the country’s trade and current account imbalances. The effort to increase the supply of dollars in the market must, therefore, rely on drawing down the RBI’s foreign exchange reserves or on increasing the flow of capital into the country.

The RBI has indeed opted to use its reserves in recent months, resulting in a significant decline in the volume of foreign currency assets it holds. But this has at most prevented a sharper depreciation of the rupee than has actually occurred. It has not helped correct the depreciating tendency. Continued reliance on this means of enhancing the supply of foreign exchange in the market could shrink reserves to a degree that risks triggering a speculative run on the rupee. Not surprisingly, the RBI is seeking ways of enhancing capital flows into the economy.

The rupee’s depreciation does however affect foreign investor sentiment adversely. Returns in the form of profits, dividends and capital appreciation earned in rupees deliver fewer dollars to investors. As a consequence the slowdown in foreign investment inflows induced by the global crisis and the fall in domestic growth rates has been aggravated. This poses a challenge to policy makers needing to enhance dollar availability in the market to stabilise the rupee. The RBI’s reckless response seems to be to encourage the inflow of foreign debt, since equity investments are proving more difficult to attract. Interest rates on non-resident Indian deposits have been hiked in the past and are likely to be hiked further. Restrictions on the kind of foreign agents/entities that can enter and the volume of foreign investor involvement in domestic debt markets, including the market for government securities, have been relaxed. And ceilings on foreign borrowings by different kinds of domestic entities have been raised. Such measures the government and the central bank hope would increase foreign investor interest in domestic debt markets leading to larger foreign capital inflows that contribute to stabilising the falling rupee. In a quirky response, increased foreign indebtedness is being seen as a solution to the problem of a weakening rupee.

However, since that seems to be the official strategy, opting for a reduction in interest rates would be self-contradictory. As noted earlier, even now the rupee’s depreciation is eroding the returns in foreign exchange that foreign investors in both equity and debt markets earn. If, in addition, a decline in interest rates is engineered with the aim of spurring growth, it would discourage rather than attract the debt that is seen as solution to the problem of a shortfall in dollar availability. For lack of more prudent alternative measures, that could leave the rupee floundering and convert a problem into a crisis.

In sum, focusing on the growth-inflation dichotomy to prescribe the appropriate interest rate policy may be missing the point altogether. Understanding what the central bank is doing or not doing requires examining the challenge of exchange rate management as well. That may allow a realistic assessment of how much help the corporate sector can expect from the central bank as opposed to the government.